Last month we looked at whether investors should be concerned about inflation. While many remain fixated on whether inflation will keep rising, there’s something else that could have an even bigger impact on markets and therefore your investment returns – interest rates.
Most people are aware that interest rates have been so low for so long. For those who aren’t, a quick glance at how much you’ve made from cash in the bank is a disheartening reminder. Many, however, aren’t aware of the impact interest rates could have on your wealth outside the bank – i.e., your investments.
An intro to interest rates
Interest rates are the cost of borrowing money. If you’re a borrower, it’s what you pay the lender and if you’re a lender it’s what you can expect to earn. The riskier the loan the more interest the borrower will pay to compensate the lender for the risk. That’s why government bonds, many of which are seen as virtually risk-free, pay wafer-thin interest (known as coupons) while corporate bonds, particularly higher risk ‘junk bonds’ where there’s more risk of default, pay more.
Interest rates aren’t set in stone though. They’re controlled by central banks such as the US Federal Reserve, the Bank of England, and the European Central Bank. They do this for ‘Goldilocks’ economic growth – not too much, not too little. If central banks want to boost growth they can lower interest rates, which makes borrowing cheaper and encourages spending and investment. If they want to cool an overheating economy, they can increase them which has the opposite effect.
Low interest rates are therefore viewed as generally good for businesses and stock markets. Whether interest rates rise, or fall can also have a big impact on bonds. As most bonds pay a fixed coupon, if interest rates rise that makes those coupons less attractive and so bond prices fall. If interest rates drop, it’s vice versa and happy days for bond holders.
Interest rate outlook
With interest rates in much of the developed world hovering around zero, it’s fair to ask – just how low can they go? While you might not think rates like 0.25% in the USA, 0.1% in the UK or 0% in the Eurozone can sink any lower, we can’t rule out sub-zero rates. In places like Japan and Switzerland they’re already there.
Some forecasts, however, predict interest rates to start ticking back up. Central banks use them to control rising inflation, and with many prices going up across the globe (although it’s not a foregone conclusion that’ll carry on), some see interest rate hikes as inevitable. That’s not guaranteed either though.
The Bank of England are taking a “wait and see” approach, before deciding what to do in case current levels of inflation turn out to be temporary. The US Federal Reserve has repeatedly said it expects this inflation to be “transitory”. Central banks know hiking interest rates would put the brakes on the economy and so may be reluctant to do so given post-lockdown recoveries are still underway.
What’s an investor to do?
If interest rates do rise, there’s no hiding from the fact that it likely won’t be good for markets in the short term. Does that mean investors should sell out now though, or wait before making any future investments? We certainly don’t think so.
It’s important to remember forecasts are just that –predictions, some of which will turn out to be wrong. That’s why we don’t think it’s wise to base investment decisions on uncertain outcomes. Economies and markets can be unpredictable and often catch economists and investors alike by surprise.
If interest rates do stay low for even longer, or even if they don’t rise significantly, markets could carry on doing what they’ve always done over the long term – go up. Investors waiting on the side lines could get left behind, as has happened for several years to those making pessimistic forecasts. Time in the market has been shown to increase your chances of investing success more than trying to time the market, which could even harm your returns if you get it wrong.
The Skybound Wealth approach
We don’t try to predict whether interest rates, inflation, economies, or markets will go up, down or sideways. Instead, our approach is to consider the possibilities – what if any of those scenarios happen? That means rather than swinging our portfolios around based on forecasts, we make sure they always contain a blend of different investments. So, whatever happens, there should be something performing well or providing some protection – it’s what’s called the “all-weather” approach. That doesn’t mean the portfolios will grow over every short-term period, but over the long run we expect them to deliver strong returns to help our clients achieve their financial goals.